The REIT Time to Buy

Yes, yes, I know, it's the end of the world. Bread lines, Okies trekking West, 25% unemployment and droughts are all coming back. Which is why REITs have gotten insane again, only this time on the downside. The Real Estate iShares (IYR), closed Thursday at $25.

click to enlarge

Now take a look at the ProShares UltraShort Real Estate fund (SRS), which I used to own and sold at $110-$140, and would be quite wealthy had I kept my position.  Thursday it closed at $259.

And look at the counterpart, the long version of the ProShares Ultra Real Estate ETF (URE), which closed at $3 and change.

Back in May of last year, I noted how stupid valuations had become on the REITs. I wrote:

Let me start by thanking the buyers of the REIT ETF, ticker IYR, of which I own long-dated puts.  Today, they bid it up, as they did yesterday in a Pavlovian manner on news that Archstone-Smith will be taken private.  Hopefully, the buyers will keep bidding up REITs so I can add to my short position.

For, you see, insanity reigns in commercial real estate today.  Prices of commercial real estate are as ridiculous as residential real estate was a year or so ago, and as silly as big cap growth stocks were during The Bubble.  It is no different.  And the end will be no different. ...

[C]ommercial real estate is dead ... and the REITs will face a similar fate as the homebuilder stocks. It's just that the patient is not yet aware he is dead. ...

REITs are expensive. ... let us look at multiples.  Using information on 118 REITs in the Russell 3000 comprising approximately 95% of the market cap of all REITs in the index, REITs are trading at

25.2x 2006 earnings

28.4x 2007 estimates

26.1x 2008 estimates

compared to S&P 500 (excluding financials) multiples of

20.1x 2006 earnings

17.8x 2007 estimates

15.8x 2008 estimates

Thus, REITs are trading at premiums of 25% on 2006 earnings, 59% on 2007 estimates and 64% on 2008 estimates. ...

REITs are trading at a 50% premium to stocks based on FFO! Considering that REITs used to trade at 7x-9x FFO a few years back before everyone went ga-ga over real estate, I would guess that this spread is as wide as it has ever been. ...

The market-weighted dividend on the 118 REITs is currently 4.3%. (It is 2.9% trailing for the IYR and 3.1% forward). However, REIT dividend yields used to trade within a range of 6%-10%. Also, since REITs pay out about 80% of their cash flow in dividends, the quick thumbnail calculation for cash available for dividends is 5.3% (4.3%/0.8) whereas this same calculation for the market (this time including financials) given a 30% payout ratio yields 6.0%. So REITs, which have an inherently lower rate of organic growth than stocks, also yield less when using cash available for distribution.

Lastly on valuation, complexes such as apartments and strip malls in suburbs are being purchased with an assumed cap rate - that is "capitalization" rate, similar to an internal rate of return - of 4%-5%, below the cost of financing. For prime properties, the rate is lower still. Free cash flow yield is often even lower. Thus, to merely break even, rents are going to have to go way up. Frankly, as an investment, I think that's nuts. I'll take a 5.25% T-bill rate, thank you very much.

Let us look at what REITs are valued at today:

8.7x 2008 earnings

11.5x 2009 earnings

Dividend yield of the REIT components of the Russell 3000: 15.1%

Funds from operation difference relative to the S&P 500: -27%

The REIT price to earnings ratio has fallen by 69%, the REIT dividend yield has risen by 10.8%, while FFO relative to the market has fallen from a 64% premium to a 27% discount, a swing of 91%.

Like I said last May, "For, you see, insanity reigns in commercial real estate today." This time, the insanity is on the downside. 

I expect the selling to continue, at least in the near-term given the ridiculous prices being seen in the CMBS market, which I believe is being driven by de-leveraging and technical selling. I am planning to be a buyer of the IYR below $20, or its leveraged counterpart, the URE.

I hope it gets there. Man, the market is stupid sometimes.

Comments

[Errol:]

The quality of seeking alpha article has become horrible.
So let me get this straight. We're going to see much higher levels of unemployment, less spending by consumers and lot of businesses going under and you are advising people to buy REITs?

2008 Nov 21 10:01 AM

[bluesmoke:]

The market swings much like a pendulum. I suspect you are right, but there could be some nail biting until the market corrects.

2008 Nov 21 10:22 AM

[REITBull:]

Toro-

Don't let the cat out of the bag...I am trying to buy up as much as I can at these levels.

2008 Nov 21 12:02 PM

[Augustus:]

The real problem will be in the Retail / shopping center REITs. They will not have tennants after January.

2008 Nov 21 12:30 PM

[carey_jim:]

I agree with your analysis but my only criticism is that you haven't taken into account timing.

For example, most people predicted that a housing real estate bubble was building, even in the 90s, but very few people were able to predict when the bubble would pop.

It was a game of speculative musical chairs and now the losers and whining and calling for government bailouts when they should fess up and admit that they just couldn't find a chair to sit in when the music finally stopped.

The unwinding process could last just as long as the bubble-buildup did, and while I doubt that communism will ever come to our shores, it could be a very long time until real estate recovers.

In the mean time we will all be drunk or dead and probably wont even notice the recovery until it's too late to make a profit.

2008 Nov 21 12:40 PM

[jbaug1915:]

It may be difficult for some to understand, but commercial real estate
has far more pain as lending has vanished
and vacancies are rising. Working in the industry for many years,
have never seen anything like it.

2008 Nov 21 10:28 PM